Vanguard's principles for successful investing

(MoneyWatch) Vanguard is the leader in providing low-cost index funds to retail investors. In addition to its funds, the firm's research department provides investors with a wealth of information on how capital markets really work. If you pay attention to their advice, instead of the persistent flow of "investment porn" put out by Wall Street and most of the financial media, you'll find your way to the winning investment strategy.

Readers of my books and blog know that my writings emphasize the academic research and getting investors to focus their efforts and attention on the things they actually can control -- the amount and type of risk they take, diversifying the risks they choose to take as much as possible, keeping costs low and tax efficiency high -- instead of trying to manage returns. For them, the recommendations of a new paper from Vanguard will sound very familiar.

The paper, which outlines Vanguard's core investment beliefs, begins by noting that the overarching theme running through the investment guidance they provide to clients is to "focus on those things within your control." They then note that, unfortunately, too many investors "focus on the markets, the economy, manager ratings, or the performance of an individual security or strategy, overlooking the fundamental principles that we believe can give them the best chance of success." While taking the time to read the full paper would be one of the best "investments" you could make, the following is offered as a short summary of the four major themes covered and the advice offered.

Goals

Because a plan should be tailored to your unique situation, the process should begin by outlining your objectives as well as any significant constraints. It should be long-term and designed to endure through bull and bear markets, and be flexible enough to adjust for unexpected events along the way -- what I've referred to as having a Plan B. Once the plan is in place, the investor should evaluate it at regular intervals. They note that "without a plan, investors can be tempted to build a portfolio based on transitory factors such as fund ratings -- something that can amount to a 'buy high, sell low' strategy." They emphasized that "a sound investment plan can help the investor to avoid such behavior, because it demonstrates the purpose and value of asset allocation, diversification and rebalancing. It also helps the investor to stay focused on intended contribution and spending rates."

Balance

The investment strategy should emphasize broad global diversification across asset classes and avoid exposure to unnecessary risks. It should also be built upon reasonable expectations for risk and returns. They also emphasize that while stocks are risky, having too low an allocation to them can create other risks, increasing the risk of not achieving your financial and life goals. They also note that while historical returns can provide perspective, it may not be appropriate to simply project past returns into the future. Current bond yields and stock market valuations (price-to-earnings ratios) should be considered to make sure that return expectations are realistic. "The implication is that investors may need to adjust their asset allocation assumptions and contribution/spending plans to meet a future objective that could previously have seemed easily achievable based on historical values alone."

Cost

While you can't control the markets or returns, you can control costs and tax efficiency. And the evidence is clear that lower cost, passively managed investments outperform higher cost active alternatives. You should also pay attention to "asset location" with the objective being to hold relatively tax-efficient investments, such as broad-market stock index funds or ETFs, in taxable accounts while keeping tax-inefficient investments, such as taxable bonds and REITs, in retirement accounts.

Discipline

Both bull and bear markets create emotions that lead to bad investor behavior. They can cause investors "to make impulsive decisions or, conversely, become paralyzed, unable to implement an investment strategy or to rebalance a portfolio as needed. Discipline and perspective are the qualities that can help investors remain committed to their long-term investment programs through periods of market uncertainty." Efforts to time the market rarely pay off, and they can greatly reduce the odds of achieving your goals. Enforcing an asset allocation through periodic rebalancing can help manage a portfolio's risk.

They also importantly note that "increasing the savings rate can have a substantial impact on wealth accumulation. A higher contribution rate can be a more powerful and reliable contributor to wealth accumulation than trying for higher returns by increasing the risk."

Summary

Napoleon noted that "Most battles are won or lost [in the preparation stage] long before the first shot is fired." The same is true for investing. Having a well-thought-out, written and signed plan provides you with the armor that can protect you from all the emotions that investing can evoke -- emotions that lead to counterproductive behavior. This is why it's so important to have a long-term perspective and a disciplined approach. Vanguard's advice can be summed up in this statement: "Because the future market return is unknowable and uncontrollable, investors should instead focus on the factors that are within their control -- namely asset allocation and the amount contributed to or spent from the portfolio over time."

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.